Section 37 of Income Tax Act

Section 37 of the Income Tax Act provides a crucial deduction mechanism for businesses by allowing them to claim expenses incurred exclusively for their operations. According to this provision, any expenditure that is wholly and exclusively for business purposes - except capital expenditures and personal expenses - can be deducted when calculating a business's taxable income under the head ‘profits and gains of business or profession’.

The key criterion for claiming this deduction is that the expense must directly relate to the business’s operational activities. For instance, costs such as office rent, advertising, repairs and legal fees are typically considered allowable deductions under Section 37, provided they are essential to running the business.

However, expenses of a personal nature or capital investments, such as purchasing machinery or property, are excluded, as they are covered under other sections of the Act.

Section 37 is significant because it helps businesses reduce their taxable income by accounting for necessary operational expenditures. This deduction, in turn, lowers the overall tax liability, allowing businesses to reinvest savings into growth and development.

By offering flexibility in terms of eligible business costs, Section 37 plays a key role in effective tax planning and financial management for business owners.

Section 37 and Section 37(1) of the Income Tax Act are closely related but serve distinct purposes in guiding taxpayers on the types of business expenditures eligible for deductions. Both sections apply to business expenses but differ in their scope and exclusions.

-Understanding Section 37 (1)

Section 37(1) of the Income Tax Act is a more specific provision within Section 37, which places additional restrictions on the types of expenses eligible for deductions. It focuses particularly on expenditures that are either illegal or against public policy, making it clear that such expenses cannot be deducted.

According to Section 37(1), any expenses incurred for activities that are prohibited by law or considered disallowance expenses for Income Tax are explicitly excluded from deduction eligibility. These include:

• Bribes

• Protection money

• Donations that violate public policy or are illegal

• Freebies and unethical business promotions

For example, if a business incurs costs in the form of bribes or illegal protection payments, such are inadmissible expenses in Income Tax and, therefore, cannot be claimed under Section 37(1) because they contravene the law.

This exclusion prevents businesses from benefiting from unlawful activities by claiming deductions for such expenses. This clause ensures that tax benefits are only available for lawful and ethical business expenditures.

Also Read: Section 37 (1) of Income Tax Act

-Corporate Social Responsibility (CSR) Expenditure and Section 37(1)

Another important provision under Section 37(1) is the disallowance of Corporate Social Responsibility (CSR) expenditures as tax-deductible expenses. According to the Companies Act, 2013, businesses with a certain turnover or profit are mandated to spend on CSR activities.

However, even though CSR is a statutory obligation, any expenditure incurred on these activities under Section 135 of the Companies Act cannot be claimed as a deduction under Section 37(1).

This exclusion is based on the fact that CSR expenses are considered a legal obligation for businesses and not voluntary business expenses incurred to generate profits. Therefore, such expenditures do not fall under the category of expenses ‘wholly and exclusively for business purposes’. This clause aims to ensure that businesses meet their CSR requirements but do not receive additional tax benefits for doing so.

-Key Differences Between Section 37 and Section 37(1)

The primary difference between Section 37 and Section 37(1) lies in the latter’s emphasis on the exclusion of unlawful and unethical expenditures. While Section 37 provides a broad framework for businesses to claim operational expenses, Section 37(1) introduces more specific restrictions, ensuring that tax deductions are not available for expenses incurred in violation of legal or ethical standards.

Another distinction is that while Section 37 covers a wide range of business expenditures, Section 37(1) specifically highlights certain categories of expenses that are disqualified from deductions - such as bribes, protection money and CSR expenses.

Therefore, while businesses can claim deductions for legitimate operational costs under Section 37, they must adhere to the guidelines of Section 37(1) to ensure that the expenses are lawful and ethical.

To claim deductions under Section 37 of the Income Tax Act, businesses must meet specific conditions to ensure the expenses are eligible. It is also important to understand the list of allowable expenses and disallowable expenses under this Section.

These conditions are designed to maintain transparency and ensure that only legitimate business expenses are deducted. Here are the key requirements:

-Not Personal or Capital Expenditure

The expense must not be personal in nature, meaning it should be related solely to the business or profession. Additionally, capital expenditures - such as purchasing land, machinery or other fixed assets - are excluded since these are covered under different sections of the Act.

-Not Covered Under Sections 30 to 36

Section 37 applies to expenses not covered by other sections of the Income Tax Act. If an expenditure falls under Sections 30 to 36 (which cover specific costs like rent, repairs and insurance), it cannot be claimed again under Section 37.

-Not for Illegal or Prohibited Activities

Any expense related to activities that are illegal or prohibited by law, such as bribes or fines, is not eligible for deduction under Section 37.

-Incurred Solely for Business or Profession

The expenditure must be exclusively for the purpose of running the business or profession. This means it should directly contribute to the operations or growth of the business.

-Incurred in the Previous Financial Year

The expense should have been paid or accrued in the financial year for which the tax is being assessed.

Section 37 allows businesses to claim deductions for expenses incurred solely and exclusively for the purpose of running their business or profession. These deductions fall under the category of revenue expenses and can include a wide variety of costs, such as:

-Employee Wages and Salaries

Businesses can deduct payments made to employees for their services. This includes regular salaries, wages and any bonuses or incentives directly tied to the business's operations.

-Rent, Taxes and Insurance

Rent paid for office or factory premises, property taxes, fire insurance premiums and other related costs are deductible. This includes municipal taxes on property used for business purposes.

-Interest on Loans and Overdrafts

Interest paid on loans, overdrafts or other forms of borrowing used for business purposes is deductible. For instance, if a business borrows funds to purchase inventory, the interest on that loan can be claimed under Section 37.

-Repairs and Maintenance

Costs for maintaining or repairing assets such as office equipment, machinery or property used for business purposes can be deducted. This includes routine repairs and any minor modifications to keep business assets in working order.

-Travel Expenses

Expenses incurred during business travel, such as transportation, lodging and meals, are deductible. These costs must be directly related to the company's business or professional activities.

-Advertising and Promotion

Costs incurred for advertising and promoting the business, such as newspaper ads, social media campaigns or billboards, can be deducted. Sales promotion expenses, including discounts or incentives to customers, also qualify.

-Professional Fees

Payments made to professionals like lawyers, accountants, consultants or any other expert services used in the business are eligible for deduction. These fees must be tied to services that contribute to the company’s operations.

In addition to these, Section 37 allows deductions for expenses related to research and development activities. This can include costs associated with market research, experimenting with new products, or developing new technology. Other deductible expenses include:

• Employee welfare expenses

• Bonuses or gifts to employees

• Fees paid to the Registrar of Companies for legal compliance

• Festival-related business expenses

• Telephone and internet bills

Let us take an example to understand this better:

ABC Pvt. Ltd. took out a loan to upgrade its business infrastructure in the last financial year. The company paid ₹3,00,000 as interest on the loan and ₹75,000 as brokerage fees, stamp duty and related costs.

Under Section 37, ABC Pvt. Ltd. can deduct ₹3,75,000 from its taxable income as these expenses are directly tied to running its business. This deduction helps reduce the company’s overall tax liability, providing a financial benefit for legitimate business expenses.

To better understand the types of disallowance under Section 37 or the expenses that do not qualify for deductions under Section 37, let us look at another example.

Consider that XYZ Tech Solutions Pvt. Ltd. decided to renovate its office building to enhance the working environment completely. The company spent around ₹75,00,000 on structural changes and modern interior design. Additionally, it incurred ₹40,00,000 on acquiring new office furniture and fixtures.

These expenses are done to benefit the business but are categorised as capital expenses, which are not directly related to the company’s regular operations. Hence, XYZ Tech Solutions Pvt. Ltd. will not be able to claim a deduction for these expenses under Section 37 when filing taxes.

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Section 37 of the Indian Income Tax Act is a vital provision for businesses. This section allows you to claim deductions on expenses related to your business operations. If you own a business, by understanding the eligibility criteria and learning the differences between operational and non-deductible costs, you can optimise your tax savings.

However, it is also important to note that personal, capital or any kind of illegal expenses do not qualify for deductions under this particular section. Hence, getting in touch with a tax expert ensures businesses accurately claim eligible deductions and stay compliant with tax laws, ultimately benefiting their financial health and reducing tax liabilities.